SEC Attacks the Rating Agencies

The SEC took its first swing at the failure of credit rating agencies by serving a Wells Notice on Moody’s Investor Service.

At issue, according to the Moody’s filing, is the determination in 2007 that members of one of its European rating committees “engaged in conduct contrary to Moody’s Code of Professional Conduct.”  Members of a credit committee knew that some of the products had been given inflated ratings because of a problem in the company’s risk modeling software.

Moody’s is one of only 10 Nationally Recognized Statistical Rating Organizations under the Credit Rating Agency Reform Act of 2006.

The disclosure in Moody’s 10-Q states that the SEC “is considering recommending that the SEC institute administrative and cease-and-desist proceedings against MIS in connection with MIS’s initial June 2007 application on SEC Form NRSRO to register as a nationally recognized statistical rating organization under the Credit Rating Agency Reform Act of 2006.” The theory is that Moody’s description of its procedures and principles were “rendered false and misleading” as of the time the application because of the Company’s finding that a rating committee policy had been violated.

The case reminds me of the Hennessee Group action where the SEC brought an action against a hedge fund for failing to conduct adequate diligence. The reason was that the hedge fund claimed that they had a particular due diligence program, but failed to follow the program. The diligence failure by itself was not actionable, but failing to live up to your self-professed standards made it actionable.

It sounds the SEC is making a similar case against Moody’s. In their application, they claimed to have a certain procedure but failed to follow it. We all know that credit agencies did a poor job of rating CDOs. That by itself caused damages but may not be actionable. So the SEC is going after them for failing to follow their own self-professed standards and policies.

It’s too early to tell what may happen. A worst case scenario would be removing Moody’s status as a NRSRO.  Obviously that would be a nuclear option that would destroy the company. The SEC action sounds like it is related to Moody’s ratings of just one type credit product, so the effects might be minimal.

Will the SEC go after the other rating agencies? or will Moody’s be the sacrificial lamb to warn the others?